US military strike on Syria risks broader conflict

Rising energy prices have been the first signs of another potential blow to the US economy due to a military confrontation in Syria (see post) - something the US can hardly afford at this stage. Strangely, after numerous shocks the economy has experienced in the last few years, there has been little dialogue about how well the US may be able to absorb yet another shock to growth (combined with sharply higher rates and the upcoming federal budget fight). The conflict also has the potential of delaying the Fed's exit from its securities purchase program, which will add to the uncertainty.

But there is a possibility of an even greater blow to global economic growth. A US military involvement in Syria runs a significant risk of spilling over into a regional conflict. In addition to Russian and Iranian interests in Syria, the possibility of Israel's involvement is not immaterial. Those who remember the first Gulf War will recall Iraq's Scud missile attacks against Israel in an attempt to destabilize the coalition trying to liberate Kuwait. At the time, Israel chose to take the hits from these incoming missiles without becoming involved militarily. In the case of Syria however, should the Assad regime choose to use chemical weapons on Israel, all bets are off. Israel will likely take the conflict to a whole new level.

Syria currently possesses Scud missiles which are perfectly capable of targeting Israel. In fact the nation's military has been busy moving some of these weapons in preparation for the US attack.

Reuters: - President Bashar al-Assad's forces have removed several Scud missiles and dozens of launchers from a base north of Damascus, possibly to protect the weapons from a Western attack, opposition sources said on Thursday.

The move from the position in the foothills of the Qalamoun mountains, one of Syria's most heavily militarized districts, appears part of a precautionary but limited redeployment of armaments in areas of central Syria still held by Assad's forces, diplomats based in the Middle East told Reuters.

As a comparison to the Gulf War in 1991, the Syria situation is made dangerous by the country's proximity to Israel, improved targeting, and chemical weapons capability. And while Israel now possesses US interception technology, it is by no means impermeable. Israel is certainly taking no chances and has already deployed the "Iron Dome" defense battery in the Tel Aviv area. Furthermore, Israel called in reserve troops and has been distributing large numbers of gas masks to civilians.

Adding to the risks, Iran now views a retaliation against Israel in case of a US attack on Syria as a near certainty.

FARS News: - A senior Iranian parliamentary official dismissed the possibility of a US attack on Syria, saying that Israel would be the first victim of such a war, if it ever breaks out.

"No military attack will be waged against Syria," Director-General of the parliament for International Affairs Hossein Sheikholeslam said on Monday.

"Yet, if such an incident takes place, which is impossible, the Zionist regime will be the first victim of a military attack on Syria"

While this looks like a typical belligerent statement coming out of Iran's government, it should not be ignored. Iran has been a staunch supporter of the Assad regime and is extremely well prepared militarily.

Global financial markets are clearly not ignoring the risks. In addition to higher energy prices, regional equity markets have seen increased volatility and Israel's sovereign CDS has popped some 30bp in the last couple of weeks. Let's hope the US politicians and strategists are paying attention to these signals from the markets.

Source: DB

Israel's involvement in the conflict could potentially draw in other states - directly or indirectly. The resulting casualties of a broader conflict in the Middle East in terms of lives and damage to the global economy are difficult to fathom. Not only would a US military involvement in Syria be extremely dangerous and costly, it is also unlikely to remove Bashar al-Assad from power unless the US engages on the ground. Even if the regime is somehow forced out, its replacement (which will also possess chemical weapons) could end up being just as dangerous.

Americans now have an opportunity to back out of any military involvement in Syria's mess via the upcoming congressional debates. And the majority now agrees that the nation should indeed take this opportunity.

Rasmussen (August 31, 2013): - Despite Secretary of State John Kerry’s announcement yesterday that the United States has proof of the Syrian government’s use of chemical weapons against its opponents, just 37% of Likely U.S. Voters think the United States should provide increased military assistance to protect the citizens of Syria.

The latest Rasmussen Reports national telephone survey, taken Thursday and Friday nights, finds that 40% do not think the United States should get more involved militarily in Syria. 

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From our sponsor:

One reason for recent Brent-WTI spread narrowing originated outside the US

For the first time in some 2.5 years Brent-WTI spread (discussed here) has traded around $5/barrel. The two types of crude oil represent nearly the same product but have been trading at a wide spread due to difficulties of transporting sufficient amounts of North American crude from Cushing Oklahoma, where WTI is settled, to the Gulf of Mexico where it could be delivered to major US refineries or shipped elsewhere as a replacement for the more expensive Brent crude. These delivery challenges have been significantly reduced in the past couple of years. At the same time some technical issues in the North Sea have been resolved to stabilize Brent pricing.

Bloomberg: - The drop in the gap between Brent, a gauge for more than half the world’s oil, and WTI shows how improved pipeline networks and the use of rail links have helped to unlock a glut at America’s oil-storage hub at Cushing, Oklahoma, in line with a prediction made by Goldman Sachs Group Inc. as long ago as February 2012. WTI rose 5.2 percent in the first half of this year. Brent dropped by 8.1 percent as North Sea supplies have stabilized following oilfield maintenance.

“The spread is coming in on anticipation that we’re going to see pipelines get built and more rail capacity put in place,” said Bill O’Grady, chief market strategist at Confluence Investment Management in St. Louis, which oversees $1.4 billion. “There is now a likelihood that not only will U.S. imports drop further, but that the country will be exporting before long.”

But there is one question that still remains unanswered. A major portion of the spread compression to $5 has taken place just in the past few weeks. Moreover, the volatility of the spread has fallen dramatically.

It is highly unlikely that the market just came to a realization in mid-June that "improved pipeline networks and the use of rail links have helped to unlock a glut at America’s oil-storage hub at Cushing". The transport dynamics in the US have been improving for some time - so why should the spread collapse now?

Something else happened in mid-June that started this steady decline. It was the Iranian elections.

CNN: - Iranian centrist candidate Hassan Rouhani won the Islamic republic's presidential election Saturday after campaigning on a "hope and prudence" platform in which he appealed to traditional conservatives and reform-minded voters alike.

Rouhani spoke of reforms without threatening Iran's supreme leader or its institutions, of which he is a product. The former national security council chief promised an environment with greater personal freedoms and even indicated he would free political prisoners and jailed journalists.

The outcome of this election greatly reduced the risk of a major conflict with Iran, thus lowering the "Iran premium" priced in Brent-WTI spread. This premium existed because a military clash with Iran would impact Brent (and similar regional blends) supply and pricing to a far greater extent than WTI. This change also opens the door for a potential lifting of the sanctions against Iran, making supply disruption risks even lower. Given Iran's nuclear work, the risks are clearly still there, but the market is perceiving them to be materially reduced.

While the transport fundamentals in the US have definitely driven the spread lower over the past year, it was the elections results in Iran that precipitated the rapid collapse in this widely watched spread.

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From our sponsor:

With oil production capacity declining, Iran is becoming marginalized

Facing concerns about dwindling oil production capacity (ability to supply incremental amounts of crude into the market) Iran responded back in April with a statement that the nation has plenty of spare capacity and is simply dealing with weak global demand.

FARS: - "The current capacity of Iran's crude oil production is 4.2 mb/d and we are currently supplying oil as much as the world market needs," [Iranian Oil Ministry Spokesman Alireza Nikzad Rahbar] said.

According to Iranian officials the demand weakness in global crude markets is mostly due to slowing economic growth in the US - driven by US budget cuts.

FARS: - According to Khatibi, following the failure in solving budget issues, the US administration has decided to reduce its expenditures, which in turn can have an impact on
economic growth and oil demand by the country.

... "These days those negative factors including slowdown in oil demand growth and worsening economic outlook in industrial countries especially the US are prevailing in the market," he added.

The statement basically says that Iran can provide all the extra crude the world needs, and would have produced more if it wasn't for the faltering US economy. But all this wonderful rhetoric aside, does Iran really have the capacity to produce 4.2 million barrels of oil per day (mb/d)? According to JPMorgan, the nation's current capacity is actually closer to 3.3 mb/d. Moreover, the capacity is expected to continue its decline.

Source: JPMorgan

The sanctions have curtailed Iran's ability to apply some of the more modern techniques to improve oil field capacity. The nation's industry continues to rely on re-injecting natural gas back into the huge but aging fields to maintain pressure. Over time this traditional extraction technique will result in falling yields.

In spite of Iran's problems, OPEC's capacity is expected to continue to rise. Nations such as Iraq will more than compensate for Iran's dwindling capacity (chart below). In the end Iran is becoming increasingly marginalized as an oil producer, both within OPEC and outside - particularly as North American production ramps up. And unfortunately in this increasingly competitive energy supplier environment, it will be Iran's ordinary people who will feel the brunt of the nation's capacity constraints.

Source: JPMorgan

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From our sponsor:

Iran to voluntarily curb crude oil export

A couple of weeks ago the IEA announced that Iran's oil exports have spiked to 1.3 million barrels per day (mbpd) in October from 1 mbpd in the summer. The explanation seems to be increased purchases from Asia.

Reuters: - The IEA said Iranian oil output rose by around 70,000 barrels per day (bpd) to 2.7 million bpd in October [from 2.63 million barrels per day in September]. Iranian exports jumped to 1.3 million bpd from 1.0 million seen in the two previous months.

"China and South Korea appear to account for the lion's share of the increase in Iranian imports," the IEA said in its monthly report.

The jump in imports could have brought Iran an additional $900 million last month, according to Reuters calculations based on the price for its oil of $100 a barrel.

Iran has been able to rename and "re-flag" its cargo ships multiple times to get around the sanctions. Some cargoes exchange and blend crude directly from ship to ship off the coast of Malaysia - with non-Iranian ships then headed for destinations "unknown".

But as discussed earlier, China wants to develop a more reliable source of crude, which will be coming via a pipeline from Russia (see post). The Russian crude oil pipeline will open up a whole new market (ESPO) in the Sea of Japan. This is expected to reduce demand for Iranian crude.

Possibly in response to these dynamics, Iran all of a sudden announced today that it will cut exports back to the low levels of the summer: 1 mbpd in 2013 (vs. 1.3 mbpd from the latest IEA number).

FARS: - "Apparently, the government wants to decrease the 1392 [note that in the Solar Hijri calendar, year 1392 starts March 21, 2013] state budget's reliance on oil exports to one million barrels a day," member of the parliament's Budget Planning Commission Gholamreza Mesbahi Moqaddam told FNA on Monday.

He said that the parliament is not concerned about deficiency in the 1392 state budget due to the western oil sanctions for the country sees crude embargos as an opportunity to reduce or even cut the country's reliance on oil exports.

The official explanation of course is Iran's desire to reduce dependence on crude exports. It's a step in the right direction, but that's something the nation should have initiated years ago rather than during this crisis (see discussion). The announcement constitutes a change in direction and took some market participants by surprise. Also if production is reduced for a prolonged period, it may impair long-term output capacity. Brent futures however have not responded. Some traders are saying that this is a bluff in an attempt to boost oil prices or the market is simply well supplied even if this reduction in output is real.

Brent July 2013 contract (source: barchart)

What is true is that Iran has a limited storage capacity for excess oil, which may explain some of the need to cut output. Iranian TV reported big plans to build new storage capacity.

Reuters: - With exports down sharply and fewer oil tankers available to store the excess, Iran's Press TV reported on Sunday that Iran plans to build millions of barrels of additional storage facilities in the Gulf over the next few months.

"By the middle of the next year, nearly 8.1 million barrels will be added to the crude oil storage capacity of Iran," Press TV reported the managing director of the Iranian Offshore Oil Company (IOOC), Mahmoud Zirakchian-Zadeh, as saying.

These developments are important to watch going forward because crude oil and petrochemicals exports are Iran's lifeline to obtain hard currency. With its economy in distress, access to hard currency will be increasingly important in order to satisfy the population's most basic needs.

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From our sponsor:

As crude prices decline hurting revenues, Iran threatens to cut off supply

Crude oil prices have been on a steady decline in the past couple of weeks as global demand remains weak. These declines are pressuring Iran, who is already selling oil below market prices. That's why it was no surprise today when Iran tried to prop up prices by threatening to cut off oil sales altogether.

Reuters: - Iran said on Tuesday it would stop oil exports if pressure from Western sanctions got any tighter and that it had a "Plan B" contingency strategy to survive without oil revenues.
... 

"If sanctions intensify we will stop exporting oil," Iranian Oil Minister Rostam Qasemi told reporters in Dubai.

Qasemi's statement is the latest in a series of threats of retaliation by Tehran in response to the sanctions, which have heightened political tensions across the Middle East and, analysts say, led to a sharp drop in Iranian oil exports.

"We have prepared a plan to run the country without any oil revenues," Qasemi said, adding, "So far to date we haven't had any serious problems, but if the sanctions were to be renewed we would go for 'Plan B'.

"If you continue to add to the sanctions we (will) cut our oil exports to the world... We are hopeful that this doesn't happen, because citizens will suffer. We don't want to see European and U.S. citizens suffer," he said, adding that the loss of Iranian oil on the market would drive up oil prices.

Brent rallied on the announcement but not nearly enough to offset recent declines.

Source: FOREXPROS

Market participants don't believe Iran would cut off its only major source of funds to "punish" the West. This simply shows an increasing desperation of the government as it tries to cling to power. Internal rift within the government is escalating (see NYTimes story), and it looks increasingly likely that Ahmadinejad is on his way out. It is possible that he will be used as a scapegoat by his successor who will blame him for the nation's deteriorating economic conditions. Additional declines in oil prices combined with increased sanctions from the EU and the collapsing currency will further destabilize and already strained political situation in Iran.

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Latest developments in Iran: conditions becoming increasingly desperate

More worrisome signs are emerging of deteriorating economic conditions in Iran. Here are some of the latest news quotes:

1. Crude output is slowing.

NYT: - Daily oil production in Iran, the most important component of its economy, fell in September to the weakest level in nearly a quarter-century, according to monthly data released on Friday by the International Energy Agency. The agency forecast declines in Iran’s ability to produce oil for years to come if Western sanctions were not lifted

2. Trade in general has come under severe pressure. This is likely having a terrible impact on the population, particularly the poor.

Reuters: - Data from maritime intelligence publisher IHS Fairplay showed the overall number of vessels calling at Iranian ports in the year to early October was 980. That figure for more than three quarters of this year compares with 2,740 ships for the whole of 2011 and 3,407 for 2010.

Of that total, the number of visits by container ships - which carry consumer goods ranging from foodstuffs and household items to clothing and toys - was 86 so far this year, compared with 273 for the whole of 2011 and 378 in 2010.

The world's top container firm Maersk Line said this week it had stopped port calls to Iran, citing the risk of damaging trade opportunities especially in the United States.

"Lower shipping volumes may also mean that importing vital commodities will be increasingly hard, leading to possible riots over inflation," said Alan Fraser, Middle East analyst with security firm AKE.

Only eight refrigerated cargo vessels carrying fresh produce including bananas called at Iranian ports so far this year, down from 16 in 2011 and 36 in 2010, the IHS Fairplay data showed. Even fishing trawlers unloading their catch have slumped to five from 14 last year and 20 in 2010.

Starved of dollars as the sanctions curb oil exports, Iran bought large amounts of grain earlier this year using other currencies. Nevertheless dry bulk ships, which can carry cereals and commodities such as coal and iron ore, have also made fewer port calls with 100 arrivals so far compared with 352 in 2011 and 406 in 2010.

3. We are beginning to see the first signs of social unrest. But given the brutality with which the authorities are likely to respond, the protests have been largely subdued.

The Telegraph: - Economic hardship has triggered the first street protests in Iran for three years as Tehran struggles to cope with UN, US and EU measures imposed to punish the country for violating resolutions restricting its nuclear programme. Western officials believe that sanctions have put the regime under pressure. "There has been a wider effect on the economy and that affects people and businesses."

In a rare public concession that the regime was struggling with the sanctions, Ayatollah Khamenei decried the measures this week. "These sanctions are barbaric," he said. "This is a war against a nation. But the Iranian nation will defeat them."

4. Foreign firms are exiting Iran to avoid losing business with Western nations.

Reuters: - Iran has faced an exodus of international companies providing marine-related services including certification of its fleet, which is vital for securing insurance and ports access. Earlier this year, sanctions pressure also led to the near collapse of an Iranian-led shipping venture with an Indian firm.

5. Auto production is declining sharply.

NYT: - On Thursday, the Iranian Students’ News Agency reported a 42 percent drop in automotive production in the past six months compared with the same period a year earlier, without providing an explanation. But the rial’s severe drop has made imports of auto parts far more expensive. Last February, Peugeot, the French automaker that is a partner of Iran Khodro, Iran’s leading domestic automaker, withdrew from the country because of the strengthened Western sanctions.

6. The EU is about to impose harsher sanctions that will be focused among other things on financial transactions.

WSJ: - European firms will be banned from contracting any ships to transport Iranian oil—even if they are from outside the bloc. There will be a ban on marine equipment sales and European firms will be prohibited from constructing oil tankers for Iran.

But the most effective measures may be in the financial sector. Even for trade that is still allowed, there will be tight thresholds on transactions with Iranian banks that can go ahead without authorization.

The level of the threshold will depend on the sector, with humanitarian trade in food and medicines having a ceiling of €100,000. But for many other items, any tr ansaction over €10,000 with an Iranian bank will need pre-approval, diplomats said.

7. There are stories of increased tensions within the Iranian government, although so far there isn't much evidence to substantiate such claims. A rift within the government could trigger wider, potentially violent internal conflicts (as discussed here).

NBC: - [A Western intelligence] official told NBC News there are some signs of “tension within the Iranian regime” over the issue.

"We’ve picked up some small signs of wavering on the nuclear policy," the official, who did not want to be named, said. "But I don’t want to exaggerate it."

This situation needs to get resolved soon. One can only hope these events do not result in a massive humanitarian crisis, because the current situation has all the makings of one.

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Iran on the brink

Iran's internal instability continues to pose significant risks to the region. As discussed earlier (see post), the currency collapse has triggered hyperinflation.

Bloomberg/BW: - The run on the rial has exacerbated inflation that had already been pushed up by the removal of subsidies on energy and food. The official rate rose to 23.5 percent in August. The real rate, which adjusts for the currency depreciation, is three times that, according to Steve Hanke, a professor of applied economics at Johns Hopkins University in Baltimore.

“We’re getting into what is technically hyper-inflation,” with an “implied inflation rate” of about 70 percent a month, Hanke said.

As a result Iranians with money are trying to preserve their wealth by buying gold. Gold sales to Iran have spiked.

Bloomberg/BW: - Turkish sales of precious metals to Iran jumped to $6.2 billion through July from $21.9 million in the same period last year. Wealthy Iranians in Turkey are collecting gold and exporting it to Iran, the Istanbul-based Zaman newspaper said July 11. Iranians in Dubai and India are also collecting gold and sending it to the central bank, Zaman said, citing a Turkish economy administration official it didn’t name.

These developments may be a precursor to a sharp increase in social unrest. As the well-off Iranians have the ability to preserve their wealth (at least in part), the gap between the rich and the poor widens. In the late 70s similar conditions (including high inflation and gold buying by the wealthy) preceded militant anti-Shah demonstrations and ultimately the 1979 Islamic revolution.

Once again, the mass media doesn't seem to be focused on these developments - in part due to lack of understanding of history. One doesn't need to focus on the history of Iran to appreciate how dangerous the situation has become. Currency debasement and inflation were responsible for hostilities through the ages. Here are a couple of well known examples (h/t Josh):

1. In ancient Rome the dilution of the currency (reducing the silver content of the coins) led to widespread anti-Christian (and other types of) violence in the early 300s AD.

Source: SocGen (click to enlarge)

2. A hyperinflationary environment in Britan in the late 1500s to mid 1600s sparked increasing incidence of witch trials. Note that in the chart below "1" on the left-hand axis stands for 100%
.

Source: SocGen (click to enlarge)

Whether it was Christians in the Roman era or women in the middle ages, someone was blamed and terrorized in times of collapsing currencies and hyperinflation. This pattern repeated itself numerous times throughout history. 1000% inflation (in the summer of 1917) ignited the Russian revolution and the hyperinflation in Germany after WW-I had well known disastrous consequences.

Iran is no exception. In the 70s the Shah and his regime was to blame. The only question now is who will be the target of people's rage and desperation this time.

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Iran's currency trades at 65% discount to the official exchange rate as hyperinflation sets in

Given the numerous discussions on Iran (such as this one back in August), it should come as no surprise to Sober Look readers that Iran's economic conditions are spiraling out of control. Iran's currency (discussed here) has collapsed. The official exchange rate has been kept fairly constant - currently at 12,365 rial to the dollar. The street value however hit a new low of 35,000 rial to the dollar - a whopping 65% discount to the official exchange rate (see chart).

Bloomberg: - The rial fell to a record low of 35,000 to the dollar on Oct. 1, an 18 percent drop, on the unofficial market. The currency has plummeted since November when it traded at 13,200 to the greenback.

The currency weakness has accelerated an already unsustainably high inflation rate, sparking unrest that shut down most black market foreign exchange shops.

Bloomberg: - Most foreign currency shops and outlets in Tehran’s Grand Bazaar were shuttered today while hundreds of Iranian riot police patrolled in the downtown area a day after protests over the tumbling national currency.

Police units were visible around Ferdowsi and Manouchehri streets, near one of the main areas for currency traders in the capital, as well as roads surrounding the Grand Bazaar further south. The minority of exchange houses that did open failed to display prices or carry out transactions.

In a classic sign of hyperinflation, the hoarding of goods is now spreading through the economy.

Bloomberg: - People “are nervous about tomorrow and next week because they don’t know how much more expensive things will be,” said Mostafa Daryani, 52, whose family owns a Tehran supermarket chain. “They only buy their daily needs and ignore most of the things that are not urgent for daily life. Instead of one bottle of milk, they buy two.”sales, he said.

Prices of home appliances have doubled in the past six months and some shopowners prefer to hoard goods rather than sell them in the hope that they can get higher prices in the future, said Yahya Ebrahimi, 48, who owns an electronics store in central Tehran. Merchants are increasingly using the dollar value of items as the basis for sales, he said.

At this point even if the sanctions are lifted, any resolution to this economic crisis in Iran has become untenable.

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In Iran it's all a matter of trust in leadership

1. Iranian Oil Minister:

Iranian Oil Minister Rostam Qassemi

FARS: - "The amount of the country's crude oil production this year will be the same as the production last year," Qassemi told the Iranian students news agency. 

...

Qassemi's remarks also showed inefficiency of the western sanctions on Iran's oil industry. The European Union banned imports of Iranian oil starting July 1.

Qassemi further added that a number of new oil and gas fields had been discovered in the last year and new figures for the country's reserves would be announced shortly.

"Iran's crude is being supplied on the world markets and Iran has its traditional buyers," Qassemi told Shana, Iran's oil news website, on Wednesday.

2. Western and Zionist propaganda:

Bloomberg OPEC Crude Oil Production Output Data: Iran

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In the streets Iran's currency trades at 52% discount to the official exchange rate

Internal conditions in Iran continue to deteriorate. The street value of Iran's currency (the rial) has hit new lows as the currency decline spirals out of control.

NBC News: - Street traders in Iran say the country's currency has struck a new record low against the U.S. dollar, the second consecutive day it has fallen sharply.

They say the rial on Monday dropped some 5 percent, with 25,650 rials now needed to purchase one dollar. A day earlier it fell nearly 7 percent.

The currency's slide is a sign Western sanctions over Iran's nuclear program are biting, although Iran says it has enough reserves and blames nervous markets. The West suspects Iran aims to build nuclear weapons. Iran denies that.

That's a whopping 52% discount to the official exchange rate.

And foreign currencies are even more difficult to access these days because international banks are reluctant to help Iran set up foreign accounts, transfer funds, or otherwise transact globally. This is driven by the situation with Standard Chartered and HSBC (who got themselves into a bit of trouble). Some banks in China have supposedly been helping Iran (see this NYT article), but that's probably been shut down as well.

With no official payment systems in place and no access to foreign currency accounts, Iran is buying up gold from Turkey to use as a form of currency. Since gold does not pass through central banks' controlled payment systems, it is harder to track Iran's transactions that may violate Western sanctions.

WSJ: - Gold exports [from Turkey to Iran] in the first seven months of the year are already five times more than the total in 2011 owing to rising demand from Iran, which accounted for only 4% of sales two years ago, when its purchases started.

Without access to foreign currency (and unable to afford dollars in the street), the Iranian people are no longer able to travel abroad and are effectively trapped in their own country (the official exchange rate is only permitted for pilgrimage trips).

LA Times: - Homayoun Hashemi had imagined visiting his daughter, off studying in the United States. But as the value of the Iranian rial plunges, that trip is steadily slipping out of his reach.

“Now my wife and I are almost forbidden to go visit our daughter,” the 60-year-old engineer lamented. “The trip is not affordable.”

As Iran is pressed by Western sanctions over its disputed nuclear program, the beleaguered economy is putting added pressure on ordinary Iranians through inflation and triggering pleas for the Iranian central bank to step in.

The official inflation number out Iran stands at 23.5%, but anecdotal evidence suggests that it is much higher. A number of Iran's politicians are apparently pushing for the central bank to stabilize the currency.

Reuters: - The rial's slide threatens to push up inflation and fuel capital flight from Iran and has inflamed political divisions within the country, with foes of President Ahmadinejad in the legislature accusing his administration of foot-dragging and exacerbating the situation.

A group of a few senior lawmakers heaped criticism on the central bank and its governor Mahmoud Bahmani for failing to stabilize the currency during a closed meeting in parliament on Tuesday, the Mehr news agency reported.

"Most of the discussions of representatives was for the government to enter the exchange market as quickly as possible and inject currency," said Gholamreza Taj-Gardoun, the deputy of the parliament's planning and budget committee, according to the Iranian Students' News Agency (ISNA).

But the central bank has no such ability. The only way the currency can be stabilized is if the central bank were to use its reserves of dollars (or gold) to buy the rial. And it is highly unlikely that Tehran will support such action given how precious foreign reserves are currently.

Iran's official answer to the economic conditions spiraling out of control is to develop a "sanctions resistant" economy via a series of projects called Mehre Mandegar (Lasting Kindness).

FARS News: - [Mehrabian, a former industries minister] said of 905 Mehre Mandegar projects, 52 projects are underway in oil industry, worth 700 trillion rials, adding completion of the projects will have a remarkable impact on the country's economic growth especially on employment.

He added that the 9th and 10th administrations of President Mahmoud Ahmadinejad, have accelerated implementation of projects in comparison with former administrations amid remarkable rise in total investment.

"One reason why current administration insists on completion of Mehre Mandegar projects is that the government believes that it should use its mandate and budget to complete half-finished projects so that next administrations to be able to start new projects and to start a new era in industrial and economic development of the country."

The street currency traders however are not holding their breath for these "projects" to be completed as the rial continues to fall.

SoberLook.com

Iran may be successfully smuggling oil, avoiding customs

Iran's oil output hit a new low recently as sanctions, particularly those from the EU took hold. The chart below points to an unprecedented collapse in production. And it is estimated that Iran's oil exports are now down some 66% YoY.

Iran's crude oil production (Bloomberg/OPEC; unit = 1000 barrels/day)

But are the official export numbers right or is Iran finding ways to get around the sanctions? According to Bloomberg, Iran's tanker fleet is now on the move. Since February Iran's tankers have been used for storage of excess oil that could not be sold into the market because of the sanctions. These ships were kept stationary. But now Iranian crude carriers seem to be on the move.

Bloomberg: - Iran’s tanker fleet is the busiest since February as fewer vessels store unsold oil at sea and more switch to transporting cargoes that most crude carriers are barred from hauling, said EA Gibson Shipbrokers Ltd.

The number of very large crude carriers operated by Tehran- based NITC in use for floating storage fell to 10 by the end of August, Steve Christy, director at London-based Gibson, said by phone today. That was a six-month low, he said.

“More of these ships are being used to move crude sales into the international market, rather than to store unsold cargoes in the Middle East region, which is what was happening in 2010,” Christy said.

This seems to indicate that in spite of the official export numbers hitting new lows, Iran may be successfully bypassing customs registration and smuggling crude to some buyers - likely at a discount to the market. Of course Iranian authorities and companies would never admit to the part about the discount. The smuggling part however is another story. Iran has recently all but admitted to smuggling, and may now be in fact using this "export" capability as a propaganda tool.

Tehran Times: - ... Oil Minister Rostam Qasemi said that although the West has imposed sanctions on Iran’s oil sector with the goal of toppling the Islamic establishment, the country’s oil exports will never be halted because oil consuming countries need Iranian crude.

“There are many ways to easily sell oil, one of which is to take advantage of businessmen and the private sector,” Qasemi added.

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Alarming parallels between current Middle East tensions and events leading up to WWI

JPMorgan's commodities analysts draw some frightening parallels between the current Israel - Iran tensions (discussed here) and the events leading up to World War I. They first point out that since the tensions have not escalated into a military conflict so far, in spite of numerous predictions, the public has lost "interest" and the markets moved on to other issues. The web search interest for the phrase "iran war" has dropped off significantly since the peak of early 2012.

Source: Google Insights for Search

But that does not mean the risks have dissipated, particularly as Syria becomes a "wildcard".

JPM: In our view, the probability of a unilateral military strike by Israel against Iran has increased from low single digits (2% to 5%) in January 2012 to low double digits (10% to 15%) in August 2012. We think conventional wisdom vastly overestimated this risk in 1H2012, lost interest when missile volleys did not occur by June, and now underestimates the importance of recent threats by the Israeli leadership and the soul-searching public debate taking place within Israel about the wisdom of a preemptive strike.

Israel's highly "optimistic" assessment of the costs of such a conflict (see this article) ignores history and raises the possibility of a major strategic error.

JPM: - It is a red flag when any state claims a military conflict it unilaterally starts will be contained to a short duration (30 days, say the Israelis) and limited homeland casualties (500 dead). This bluster ignores important lessons from history, such as are found in Barbara Tuchman’s masterpiece analysis of the causes of World War I, The Guns of August. We spotlight 10 lessons from that analysis and how they apply to commodity risk today.

JPMorgan sees 10 parallels with the errors made during the period leading up to World War I (based on Barbara Tuchman’s The Guns of August.)

JPM:... the principal lessons as we see them are: (1) mobilization for war—“to send a message”—can create unexpected momentum that results in a massive war no one intended actually to start, (2) expectation for swift war can be a tragic miscalculation, (3) casualties and human carnage can be far higher than thought possible, (4) beware of fighting the last battle—military planning based on historical experience and stale assumptions leads to mistakes, (5) who strikes first matters—global public opinion may turn against the first striker, especially if that state tries to use subterfuge to implicate wrongly its opponent as the first striker, (6) the best laid plans are vulnerable to chaos, (7) unilateral actions can be perceived as reckless, forcing surprising shifts in formerly rock-solid alliances and forcing neutral sovereigns into active engagement, (8) significant economic integration is insufficient inoculation to prevent total war and prosecution of war can persist even if it means economic devastation, (9) appeals to national pride are insufficient to prevent political backlash to and moral condemnation of voluntary war, and (10) random events in proxy conflicts can be the catalyst for general war.

The table below is an overview of these parallels as well as the actual outcomes of each of the decisions.

Source: JPM (click to enlarge)

Based on the fact that such a conflict risks becoming far broader and deadlier than the early assessments, JMorgan's view is that oil prices would spike initially but would then decline below current levels as global demand comes to a halt.

JPM: - It is a nearly universally held belief that an Israeli attack must result in a large oil price spike, at least at first. Markets seem to be ill-prepared for the very real potential outcome that an attack could be followed by a strong downdraft in petroleum prices, like the one that followed Japan’s Tohoku earthquake last year, despite the loss of 1.2 mbd in Libyan crude output. If an attack occurred, we would not be surprised if the initial impulse were a smaller-than-expected and briefer-than-expected oil price spike followed by a stronger-than-expected oil price decline. ... [The decline would be driven by] large and unexpected damage to global commodity demand, while simultaneously boosting oil supply through release of strategic oil stocks.

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Brent-WTI spread blows out again

As discussed back in June, the projections of Brent and WTI crude oil convergence did not materialize. Goldman's prediction that we will see $5 spread between the two crude oil markets by the end of this year was wrong. The expectations that the Seaway pipeline will deliver sufficient amounts of US crude to the Gulf to force convergence just didn't materialize. The spread touched $20 a couple of days ago.

Brent-WTI closing prices (Bloomberg)

Bloomberg: - Lost crude production from the North Sea to Iran has driven the disparity between the world’s two most-traded oil grades to the widest in more than nine months, threatening to undermine Goldman Sachs Group Inc.’s forecast that they will become more aligned.

North Sea Brent remained at least $20 a barrel more expensive than West Texas Intermediate in the five days through yesterday after the gap almost doubled since June 20, according to data compiled by Bloomberg. Goldman Sachs has predicted since April that the spread will drop to $5 a barrel in three months.

The growing difference underscores how falling output from the North Sea’s aging oilfields and U.S.-led sanctions on Iranian crude sales are stoking Brent while a production boom that’s deepening a glut of landlocked U.S. supplies limits WTI’s gains. BNP Paribas SA, Citigroup Inc. and Commerzbank AG say the spread is unlikely to narrow any time soon.

At least a portion of this spread increase is driven by escalating rhetoric coming out of Israel. And it is no longer just speculation or media hype. It seems that Israel's officials are seriously considering a military strike (also discussed here).

JPost: - Setting Iran’s nuclear plans back a few years to buy time for regime change or other unforeseen developments would be good in its own right, even if Israel cannot completely take out Iran’s nuclear program, Prime Minister Binyamin Netanyahu said recently, The Jerusalem Post has learned.

Netanyahu, in private meetings, repeated a number of times that before Israel’s 1981 attack on Iraq’s Osirak nuclear reactor, the Mossad and Military Intelligence were opposed because they thought the best that could be done was to delay the program for a couple of years.

With the heightened geopolitical risk, Brent is now viewed as having a great deal of the upside, while WTI, impacted by strong domestic production in the US, has the downside. This divergence is keeping the spread elevated.

Bloomberg: - “The Brent oil price is biased to the upside while the other is to the downside,” said Eugen Weinberg , head of commodities research at Commerzbank in Frankfurt. “On the WTI side, there are still high inventories, very high domestic production, high imports and anemic demand. On the other hand, maintenance work in the North Sea and latent geopolitical risks are pushing Brent higher.”

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Crude oil denominated in euros hits record

Brent crude oil priced in euros hit a new high closing price today of €94.83/barrel, exceeding the highs reached in 08 as well as early this year.

Source: Bloomberg

This rally has been driven by four factors:

1. The euro is down close to 15% over the past year.

2. Draghi's "Believe me, it will be enough" statement increased demand for "risk assets". Bets on additional central bank stimulus are pushing up crude prices.

3. An unexpected decline in US crude and gasoline inventories added to the upward pressure on crude.

4. Israel's rhetoric on Iran is not helping matters either (particularly when it emanates from official sources). With tighter US supplies, it doesn't take much to spook jittery oil traders. The "Iran premium" currently built into the crude prices is not insignificant.

Bloomberg/BW: - Israel would be willing to strike Iran’s nuclear facilities, even if doing so only delayed its ability to produce nuclear weapons for a few years, Israeli Ambassador to the U.S. Michael Oren said.

“One, two, three, four years are a long time in the Middle East -- look what’s happened in the last year” in terms of political change, Oren said today at a Bloomberg Government breakfast in Washington. “In our neighborhood, those are the rules of the game.”

Israeli leaders have stressed this month that time is running out for a diplomatic solution to the nuclear program that Israel regards as an existential threat.

“Diplomacy hasn’t succeeded,” Oren, 57, said today. “We’ve come to a very critical juncture where important decisions do have to be made.”

As discussed before, these elevated fuel prices (based in EUR) will inflict serious damage to growth prospects for Eurozone nations - particularly for Italy who is already struggling with a year-long economic contraction.

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Iran's economic crisis escalates

Iran's leadership is now openly admitting that the nation is facing an economic crisis. Of course the cause according to them is a "temporary" form of economic "soft war" waged by the US.

FARS: "The economic crisis is, in fact, a war waged by the enemy against Iran after its failure in previous confrontations (against Iran)," Ayatollah Jannati said, addressing a large and fervent congregation of worshippers on Tehran University Campus on Friday.

He said that economic problems will not continue and are limited to a short period, and urged the Iranian nation to resist the West's economic pressure.

Iran's inflation is now out of control. Bloomberg no longer reports Iran's official inflation numbers, but the last reports through April of 2012 show some 24% CPI and runaway food inflation (running at over 5% a month). Keep in mind that this was before the North American drought that sent global agricultural commodities prices flying.

The last reported changes in Iran's food inflation 
(source: Bloomberg)

WSJ: - ... it is already apparent that sanctions have had a real effect on Iran's economic health. Statistics issued by Iran's central bank show inflation at 21%, but with the cost of staple goods rising by leaps and bounds, the actual experience of inflation is bound to be graver. The price of bread increased by 40% in the month of June alone, causing a nationwide outcry. The price of chicken and vegetables increased by 3.7% and 10% in a period of just two weeks last month. Iranian households now have to pay on average half of their monthly salaries just to keep food on the table.

Iran's central bank is now in a crisis mode.

AFP: - Iran's central bank has established a special cell to fight back against Western economic sanctions that the institution's chief described as "no less than military war," the official IRNA news agency reported on Tuesday.

"We have established a headquarters in the central bank, which meets on a daily basis" and whose task is "to manage the sanctions," central bank chief Mahmoud Bahmani was quoted as saying.

As the reserves of foreign currency dwindle, the central bank instituted currency controls for the citizens traveling abroad.

IRNA: - Governor of Central Bank of Iran Mahmoud Bahmani said on Wednesday travelers will no longer get foreign currency at official rate except for those going to pilgrimage.

Bahmani told reporters at the end of the Majlis formal session that the decision was made in the joint meeting of the government and Majlis economic teams.

The abundance of "hard currency" generated from oil and petrochemicals exports in the past had made Iran highly dependent on imports from abroad - from tools and agricultural products to gasoline.

NYTimes: - Western sanctions have hurt, economists say, particularly in denying Iran access to foreign currency reserves, which it had used to prop up the rial. Yet economists also agree that much of the damage to the economy has been self-inflicted, saying that the Ahmadinejad government went on an import spending spree after oil revenues started hitting record levels from 2005 on.

With the government buying so many goods from abroad, many domestic producers were forced to lay off workers and close factories. That, in turn, has made Iran more vulnerable to international sanctions, they say. Companies that might have helped produce goods to replace those blocked by sanctions have long since gone out of business, as the owners shifted their wealth to speculation, building and selling properties, foreign currency or raw materials.

Iran will use this opportunity to blame the West and the sanctions for all the economic problems. What's particularly troubling however is that the sanctions are not the only cause of Iran's crisis. Between years of mismanagement and the global spike in food prices it was only a matter of time.

NYTimes: - Many economists, though, say that even without the sanctions, Iran would still have big problems: a legacy of inflationary oil spending and budget-busting state subsidies of food, gasoline and other basic items that encouraged overconsumption and the steady erosion of the country’s industrial base.

“Many fundaments of the economy of our country have been destroyed over the past years,” said Mr. Raghfar, the economist. “And now, slowly but surely, the chickens have come home to roost.”

As the economic crisis escalates, Iran faces increased likelihood of civil unrest and power struggles within the government. The authorities are already preparing an army of trained volunteer thugs to take on protests, all of which would be dealt with and portrayed as an act of foreign aggression.

FARS: - Addressing a large gathering of Basij forces here in Tehran on Thursday evening, Jafari pointed to a new formation within the Basij forces known as Salehin Circles, and stated, "One of the main strategies for confronting the soft war of the enemy in cultural, political and social fields is the formation of Basij's Salehin circles."

He added that members of Salehins are taught properly how to confront enemies' cultural, political and social aggression against Iran.

The possibility of a fully destabilized Iran is becoming quite real.

SoberLook.com

Iran's game of chicken has turned into the "chicken crisis"

Per yesterday's discussion on rising food prices, it will be the people of the weaker third world economies who will suffer the most from the North American drought. The probability of domestic unrest in many nations is on the rise, though not all will pose risks to global stability. Iran however is one of those countries. Because of its military capabilities and its location in the region, a destabilized Iran could be more dangerous to world economies than the problems faced by the Eurozone or China.

Iran, which is normally viewed as one of the wealthier third world nations because of its natural resources and a relatively large middle class (about a third of the population is now considered "middle class"), has completely mismanaged its domestic agriculture. Typically that wouldn't be a problem because exports of oil and petrochemicals would pay for food imports. But recently Iran has managed to become so isolated from the rest of the world, that it doesn't even have access to the international payment systems such as SWIFT. To get around sanctions, Iran has been arranging barter transactions that do not involve cash movements, for example exchanging fertilizer for grain with Pakistan and India. And even these deals have so far been fairly unsuccessful. Nations who are able to sell grain to Iran will either want to sell their low quality product or receive a premium for quality crops. Otherwise they can simply sell the commodity in the open market and not worry about the international sanctions impacting their relations with the West.

The food problems in Iran have gotten worse even before the spike in agricultural commodity prices. Just to put things in perspective, escalating cost of chicken for example is now becoming a major problem. Prices of chicken have more than tripled in a year.

Reuters: - The soaring price for a staple food that Iranians relish cooked with saffron, plums or pomegranates has become such a hot topic of public debate, and a sign of the sinking purchasing power of many Iranians, that Police Chief Esmail Ahmadi Moghaddam felt it his duty to intervene.

He urged television stations to avoid broadcasting images of people eating chicken, saying such pictures could fire up social tensions, with perhaps unforeseen consequences.

"Certain people witnessing this class gap between the rich and the poor might grab a knife and think they will get their share from the wealthy," Mehr news agency quoted him as saying.

Mehr of course promptly took that article down. But among ordinary Iranians the inability to purchase chicken has become a major topic of discussion that is turning into a simmering political issue. Covering up images of people eating chicken is not going to make the problem go away.

Reuters: - Iranian cartoonist Mana Neyestani, who lives in France, mocked Ahmadi Moghaddam's warning with a cartoon of a young man watching a pornographic film. His father tries to cover up only the image of a roast chicken in the background of the film, saying: "How many times have I told you not to watch films with chicken in them?"

Cartoon by Mana Neyestani

Once in a while the government sells subsidized (discounted) chicken, creating long lines that represent the humiliation of the Iranian people.

Source:  ایران آزاد  blog

The Guardian: - This year, however, the [Ramadan] festivity is marred by unprecedented inflation caused by a combination of governmental economic mismanagement and western sanctions. Prices of fruit and sugar, among other staples, have soared – in some cases showing threefold and fourfold increases. The price of meat has gone up to such an extent that many now eat it only on special occasions.

The latest controversy has been branded by Iranian media as the "chicken crisis". In an attempt to bring the ever-increasing price of chicken under control, the government has filled the market with subsidised chickens, prompting long queues in places where they are sold. Some require customers to show identity cards in order to stop them buying multiple times.

And now if we overlay the rapidly rising global food prices on top of an already acute situation, many in Iran could be facing starvation in the near future. The drought shock that started is North America is about to make its way into the Middle East claiming Iranian people as its victim. In this global market it doesn't matter who will or will not be selling food to Iran. The fact remains that prices will spike way beyond current levels and there will be limited currency from oil sales to cover these rising costs. This is inexcusable for a nation with such tremendous natural resources. But the authorities in Tehran don't seem to be interested in addressing this danger in any serious way. Instead they are committed to ever more belligerent and irresponsible policies - blaming others for the troubles that the Iranian people are facing. And the scarce resources now available to the government are being diverted for other purposes.

FARS News: - A senior commander of the Islamic Revolution Guards Corps announced that the IRGC Navy plans to stage massive naval wargames in the near future in a bid to maintain its capability of defending the country's territorial waters.

Speaking on Tuesday Lieutenant Commander of IRGC Navy Rear Admiral Javad Moshidi said the IRGC naval forces will stage wargames in the near future, and added that the necessary equipment has already been supplied for the drills.

The IRGC Navy is fully prepared to carry out the exercises and will once again display its military might to protect Iran's borders, the commander stated.

SoberLook.com

Latest data from OPEC: Iraq's output catching up with Iran's

The recent OPEC report is showing that Iran's oil production continues to decline, apparently falling to a 20-year low.

FT: - Iran’s oil production has fallen to its lowest level since the aftermath of the Iran-Iraq war 20 years ago as western sanctions threaten Tehran’s economic lifeline.

Oil traders and western policy makers who monitor Iranian oil production estimate that Tehran pumped 3.2m barrels last month, the lowest amount since 1992. That is below the depressed level of 1999, when members of the Opec oil cartel implemented draconian production cuts to shore up oil prices, which had fallen below $10.

Iran's lower production is dragging down the overall OPEC output,

OPEC production tb/d

... changing the production distribution among the OPEC members. This is what the output breakdown looked like in 2010.

and here is what it looks like now.

A couple of observations from this data:
1. The Saudis are pumping considerably more on an absolute and on a relative basis.
2. Iraq's crude output is now catching up with Iran's.

Iraq vs. Iran output (source: OPEC, tb/d)

See this OPEC report for the latest data, including the demand side.

OPEC report

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Cheaper crude contributed to decline in China's import growth

There is a great deal of focus this morning on China's import growth in June. The expectations were 10.9% YOY growth, but the actual number came in at 6.3%.

China import growth YOY

It is clearly an indication of a slowdown.

NYT: - Chinese imports rose in June at only half the pace expected, government data showed Tuesday, suggesting the need for Beijing to do more to increase growth and stoking anxiety about the strength of domestic demand.

But there is another factor at play here. A big component of the decline came from crude oil imports. And since we are looking at the dollar price of imports, the recent price correction in crude oil lowered the overall amount of cash spent on fuel. The discount in crude prices for China was particularly steep as it bought Iranian oil. With China and India being the only major buyers of Iranian crude, the purchases were done below market levels.

Source: ISI Group

Clearly China bought less "stuff" last month, but buying it cheaper also contributed to the decline in import growth.

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Iran threatens action in the Persian Gulf, again

Once again Iran is threatening to close off the Strait of Hormuz in the Persian Gulf.

FARS: - "If we eventually feel that our economy, specially in the Persian Gulf, is faced with insecurity and we cannot use this economic zone for oil exports, we have the power and capacity to create insecurity for other countries' exports and will not allow any oil cargo to be exported," member of the parliament's National Security and Foreign Policy Commission Seyed Hossein Naqavi Hosseini said on Monday.

This is not a surprise and the rhetoric from Iran is expected to heat up as sanctions pressure the nation's economy.

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